Stayin' Alive

By

Jacqueline Doherty

Dec. 31, 2001 12:01 a.m. ET

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Looking back on 2001 it's tough to remember anything but September 11. The day that terrorists tore down the World Trade Center and ripped a hole in the Pentagon overshadows any merger or acquisition, corporate scandal or critical earnings report. The attacks not only destroyed much of New York's financial district and snuffed out thousands of innocent lives, but also changed the way companies and citizens alike calculate risk and conduct business.

Three months later our acute fear has faded, and images of the smoldering Twin Towers no longer make the evening news. But the ripple effects linger in corporate America in the form of higher costs for necessities such as insurance and security and sharply lower sales. All the more surprising, then, that the stock market, badly bruised in the aftermath of the attacks, has bounced back in spectacular fashion. The Dow Jones Industrial Average has risen 28% and the S&P 500 has climbed 23% from post-attack lows on September 21. In fact, they're both trading 6% higher -- the Dow at 10,136.99, and the S&P at 1161.01 -- than the levels at which they closed just prior to September 11.

As for the Nasdaq Composite, repository of technology and biotech stocks, happy days are here again, or at least expertly pretending to be. The index has soared 43%, to 1987.26, since hitting a three-year low of 1387.06 on September 21.

That's the good news. The bad news is that yearend brokerage statements still will show that stock investments in general posted negative returns for the second year in a row. With just one trading session left in 2001, the Dow is down 6.02% for the year. The S&P 500 has fallen 12.06%, and the Nasdaq, its fourth-quarter fireworks notwithstanding, has tumbled 19.56%.

Dow Jones Industrial Average

1. January 3: Alan Greenspan surprises the markets with first of 11 interest-rate cuts this year.

2. February 6: The party is really over: Cisco Systems reports disappointing earnings.

3. June 7: President Bush signs a tax-cut bill that will return $300 to almost every taxpayer this year.

4. July 3: European regulators block the General Electric/Honeywell merger, just two months before GE chief Jack Welch hands the reins over to Jeffrey Immelt.

5. September 11: Terrorists destroy the World Trade Center and attack the Pentagon, pushing the U.S. into war in Afghanistan in October. The stock market closes for four days.

As the year unfolded, the financial casualties multiplied, beginning with the final spasm of last year's dot.com implosion. With so many Internet upstarts out of business, fledgling telecom companies found few demands for their service but increased demands on their time in bankruptcy court. The telecoms' demise in turn spelled trouble for telecommunications-equipment suppliers such as
Lucent Technologies
and
Nortel Networks.
Tech stalwarts such as
Cisco Systems
and
Qualcomm
also saw their shares plunge -- again -- as investors learned that technology is indeed a cyclical business. Cisco, standard-bearer for the Nasdaq, the New Economy and perhaps the bull market itself, finished Friday at 18.54, down 52% for the year, and 77% from its all-time high.

Old Economy companies weren't spared either. With more businesses shrinking or disappearing, real-estate owners suddenly had vacancies to fill. A bear market in advertising dampened the fortunes of media and entertainment companies. Virtually no one was in the mood to merge, acquire or issue new stock to the public, which means that some investment bankers are getting pink slips in place of bonuses as 2001 draws to a close.

The upshot: The longest-lasting economic expansion in U.S. history officially ended in March, according to the National Bureau of Economic Research. Although the Federal Reserve cut short-term interest rates 11 times during the course of the year, in an effort to jump-start the economy, that didn't stop corporate earnings, the stuff of which expansions are made, from falling right off a cliff. Brokerage-firm analysts expect 2001 earnings for the companies in the S&P 500 to decline 16%-17% from last year's levels, according to Thomson Financial/First Call. That compares with profit growth of 17% in 2000.

Company balance sheets likewise deteriorated in 2001, and the delinquency rate among corporations with junk bonds rose to 10.6%. In happier days -- the spring of 1995 -- the delinquency rate was as low as 1.4%. But nothing quite rivaled
Enron's
fall from grace. The world's largest energy trader managed to destroy $67 billion in market value and default on more than $10 billion of bonds and bank debt amid an accounting scandal that ultimately revealed this emperor had few clothes. The unraveling of Enron hurt not just the meek -- unsuspecting employees and stockholders -- but the mighty;
J.P. Morgan Chase
and
Citigroup
are both Enron creditors.

Enron's demise in 2001 encapsulates much that was wrong about the glory days of the 1990s. The company relied heavily on off-balance-sheet financing and pro-forma earnings that swept some ugly things under the carpet. Like many companies, it also fooled securities analysts and employed accountants with potential conflicts of interest. Enron was snared in its own web, a fate that may yet await other stock-market hotshots and the investors who backed them.

"To me, it shows the era of unfettered belief is over. Certainly, it should be," says Steve Galbraith, chief investment officer for U.S. equity research at Morgan Stanley.

Arguably the age of unfettered belief in stock-market strategists also is past. Although many strategists correctly predicted the longevity of the 1990s' bull market, collectively they failed to foresee the unhappy course that stocks took for much of this year and last. Most of the seers profiled, along with many money managers, expected the U.S. economy to rebound in the second half of 2001 and the stock market to climb to new levels. That didn't happen, owing in part to the attacks on September 11. The bulls still believe that stocks would have rallied smartly had Osama bin Laden kept his poisonous views to himself. But the bears counter that the U.S. economy already was in recession, and that companies -- and consumers -- are struggling all across the U.S.

A small cadre of strategists expected merely muted gains in 2001, making them the least wrong of the group. Richard Bernstein, chief U.S. strategist at Merrill Lynch, and Douglas Cliggott, chief equity strategist at J.P. Morgan, both predicted the Dow would hit 11,000 at the end of 2001. Right behind -- or is it ahead? -- of them was Thomas McManus, a chief investment strategist at Banc of America Securities, with a forecast of 11,500. But Jeffrey Applegate, chief investment strategist at Lehman Brothers, and Abby Joseph Cohen, chair of the investment policy committee at Goldman Sachs, both expected the Dow to finish the year at 13,000. Edward Kerschner, chief global strategist at UBS Warburg, didn't forecast the DJIA, but pegged the S&P 500's close at 1715, some 50% above current levels.

Last year's conservative trio has subdued views of 2002. Cliggott has turned downright bearish; he expects the Dow to fall 16% to 8500, and the S&P to fall to 950. Bernstein and McManus think the Dow will continue to trade at or near current levels. Merrill's man has a yearend target of 10,000, while McManus sees 10,400 in 12 months.

In the middle of the pack is Thomas Galvin, chief investment officer at Credit Suisse First Boston, forecasting a gain of 13%, to 11,400. Ever the optimist, Kerschner projects that fair value for the S&P 500 will be 1570 by the end of next year, some 35% above the index's current price.

The bulls and the bears disagree on just about everything, prominently including the magnitude of the profit recovery that investors now anticipate. According to Cliggott, the market has priced in a 15% gain in earnings for 2002. But he argues earnings will fall 5%, or end the year flat after accounting adjustments, making stocks 15%-20% too expensive. Kerschner, on the other hand, believes stocks will rise in the second half of 2002, as investors become more convinced of an economic and profit recovery.

"The market is going through a manic period right now," Kerschner says. "On the good days it focuses on the second half of 2002, and on the bad days it focuses on the near term." The near term is likely to be dominated by more earnings disappointments, more bankruptcy filings and more bad news in general.

The optimists and their opposites also differ on the outlook for consumer spending. The bears proclaimed the death of the U.S. consumer many months ago, but were proven wrong until September 11. Only then, as unemployment spiked, did American households rein in their spending sharply. Indeed, most merchants, with the possible exception of discounters such as
Wal-Mart Stores,
are decrying their worst Christmas season in a decade.

"Rising unemployment has a double-negative effect on consumer spending," Cliggott explains. Directly, it slows income growth. Indirectly, he notes, it makes even those employed more cautious.

Cliggott predicts that unemployment will continue to rise as corporations struggle to boost skimpy profit margins. In the aggregate, margins have fallen to 8.5% from 13% at the end of 1997. The last time that happened, from 1978 to 1982, the unemployment rate climbed to 10.5%. Cliggott expects unemployment to rise to 7.5%-8% from a current 5.7%, although most strategists see a high in the mid-6% range in the current cycle.

Stuart Freeman, chief equity strategist at A.G. Edwards, in St. Louis, is more sanguine about consumer behavior. Consumer spending, which accounts for almost a third of gross domestic product, has slowed in recent months but still shows year-to-year growth. Meanwhile, lower interest rates are likely to bolster household balance sheets, as the drop in rates has prompted a surge in home-mortgage refinancing. A broad tax cut, enacted earlier this year, and the recent rise in stock prices also will help.

Freeman expects the national unemployment rate to climb just to 6%-6.5%, based on a recent slowdown in the volume of state unemployment claims. Energy prices, too, have declined -- crude oil now fetches $20.90 a barrel, down from the mid-$30s last winter, and gasoline prices in many regions have fallen below $1 a gallon. "The drop in energy prices is really like a tax cut," he says.

Not least, consumers have benefited from surprisingly resilient home prices. While there are pockets of weakness in cities such as Palo Alto, California, and New York, home prices nationwide have risen about 1%-2% this year, notes Lehman's Applegate.

The bulls and bears continue to tussle about the stock market's valuation, chiefly because they have differing views about the prospects for corporate profits. According to Thomson Financial/First Call, the consensus estimate among strategists for 2002 S&P 500 operating profits is $49.35 a share, which means the index, at Friday's close, was trading for 24 times expected earnings.

Merrill Lynch's Bernstein, for one, argues that prices are still too high. Based on the prediction of Merrill Lynch's economics team, the S&P 500 will generate reported earnings of $37.45 a share next year, implying a price/earnings multiple of 31. Investors never lost sufficient interest in the stock market to allow P/Es to compress, a necessary precursor for a new bull market, he says.

"My definition of capitulation is when people say the future will be worse than the present," Bernstein says, noting that attitude surfaced only briefly in the sessions following the September 11 attacks. Instead, growth-stock managers are chasing tech stocks again, and the market's P/E is climbing.

To some degree investors have spent much of 2001 unlearning the lessons of the late, great bull market. For years the public was told to "buy on dips," but buying when stocks fell this year only led to bigger losses. Even the old adage about not fighting the Fed when it's lowering interest rates didn't work. To the contrary, those who bet against the Fed's 11 rate cuts were rewarded with positive returns.

"Expectations were much too optimistic," Bernstein concludes. "People believed that [lower] interest rates cured all and earnings were irrelevant."

While that might have been true in the late 1990s, when companies without earnings, and some without businesses, soared to stratospheric heights, lower interest rates have proven no quick fix for what ails the economy now. In recent years companies high-tech and low produced goods far in excess of demand, and the resultant overcapacity is best cured by time -- to shutter plants, lay off workers and lower inventories -- not reduced borrowing costs.

That said, the Fed's aggressive rate cuts this year could pay big dividends in 2002, according to Wall Street's bulls. "Eleven cuts in the federal-funds rate is likely to be quite stimulative," says Edward Yardeni, chief investment strategist at Deutsche Banc Alex. Brown.

Too stimulative, perhaps. Yardeni thinks the central bank could be forced to reverse some of its largess later next year and raise rates as the economy recovers. If so, he fears, deflation could become a problem in 2003.

Morgan Stanley's Galbraith fears that lofty stock valuations may keep prices range-bound in 2002, even if earnings bounce back up in the second half, as he expects. "I think we may have a multi-year period where stocks don't do a lot," he warns. "The S&P 500 is a terribly uninteresting place to be invested today." Instead, Galbraith believes stock-picking and sector selection will be key to achieving positive returns.

Another poor year for the S&P could mark the end of closet-indexing, a practice whereby money managers construct portfolios that mimic the index in order to avoid underperforming it. Investors may find little value in paying higher management fees for such products, says Galbraith, and even less in the virtues of relative performance. Instead, truly active management, via hedge funds, deep-value funds or aggressive growth funds, could regain supremacy, a process that already seems underway. Oakmark Select, managed by Bill Nygren and Henry Berghoef, for example, a concentrated portfolio of about 15 stocks, generated returns of 26% this year, and the Third Avenue Small Cap Value Fund, managed by Curtis Jensen (who is profiled in "Star Power") returned 15%.

Bullish strategists have few qualms about the market's valuation, given that inflation is tame and interest rates are low. By the end of 2002 the core consumer price index, excluding food and energy, will drop to 1.8% from a current 2.8%, Lehman's Applegate predicts. "Inflation falls going into an economic recovery, because it is a lagging indicator," he says. Capacity utilization is still below normal levels, and finding workers no longer is an issue, he adds.

CSFB's Galvin argues that high-priced tech stocks with minimal earnings have bloated the P/E multiple on the S&P. Without its tech components the index would sell for 17-18 times earnings, which is also below the P/E of 20 implied in popular valuation models that compare the yield on 10-year Treasury bonds, now around 5%, with the earnings yield on the S&P. With higher earnings and lower rates -- a combination Galvin foresees in 2002 -- the market's multiple has room to climb, he says.

Bullish strategists also wrap their case around declining inventories of manufactured goods, which should speed the revival of demand. Inventories this year have been cut by about $100 billion, equal to 1% of GDP. The decline has been swifter and deeper than in past cycles, says Tobias Levkovich, senior U.S. institutional equity strategist at Salomon Smith Barney. In the 1990-1991 slowdown, for instance, inventories fell by 0.6% of GDP over a two-year span.

Next year, however, purge could lead to splurge. In 2002, says Lehman's Applegate, "inventories will start contributing to GDP."

Still, Wall Street's leading seers don't predict a surge in capital spending. Abby Cohen of Goldman studies CEO attitudes to try to detect a favorable turn. "To have a more vigorous economic recovery, you have to have CEOs feeling better," she says. In 2001 corporate chiefs struggled with declining company earnings and watched their own net worth plummet along with the stock market. As they grow more comfortable with the notion that the economy is stabilizing and eventually will revive, it's likely they'll spend more freely again on advertising, inventory and new employees, Cohen says. In her view, the mood at the top is improving, but the spending spree of 1999-2000 is unlikely to be repeated for a while.

Which industry sectors are likely to lead the stock market next year? Yardeni casts his vote with health care, which he calls the big winner for the next decade. "The Baby Boomers will be excellent customers," he says.

Too, the government may become less adversarial to the industry as it turns to pharmaceutical and other health-care concerns for help in fighting the threat of bioterrorism. Yardeni expects drug-company earnings to grow by 10% annually in the years ahead, well above the 5%-7% growth he sees from other companies in the S&P.

But Salmon Smith Barney's Levkovich offers a contrary view, at least for the near term. The cost of health care will remain an issue, he says, especially as mid-term Congressional elections approach.

Morgan Stanley's Galbraith is recommending the shares of basic-materials companies, despite the miserable returns they've offered in recent years. Their earnings represent only 2% of the S&P 500's total per-share earnings, down from roughly 10% a decade ago. Yet Galbraith believes the group will show stronger returns on capital than investors expect, because they've been in recession for several years and haven't gorged on capital spending. In addition, their shares trade at low P/Es based on full-cycle earnings.

Conversely, Morgan Stanley's market-watcher holds a dimmer view of financial shares because of the superlative performance lately -- they now contribute 24% of S&P earnings, compared with only 8% in 1990 and 1% in 1973. In the past 10 years financial-services providers enjoyed an ideal climate in which merger activity boomed, globalization and deregulation created new opportunities to rake in advisory fees, and the democratization of the equity market sent trading volume soaring. In addition, disinflation boosted the value of securities held in inventory, and until recently, improving credit quality enabled companies to lower their reserves.

"This was the single best environment ever for financials," Galbraith says. "My guess is it can't get better from here."

As for retail stocks, bears on consumer spending advise either avoidance or buying discounters such as Wal-Mart and
Target.
But the bulls prefer companies such as Tiffany, which offer discretionary items to a well-heeled clientele. UBS's Kerschner likes retailers that cater to the Baby Boom generation, and those that stand to benefit from the "cocooning" trend in evidence since September 11, a group that includes
Home Depot,Bed Bath & Beyond
and appliance chains.

Tech stocks have lost their glamour in the past two years but not their ability to galvanize investment opinion, pro and con. Steve Galbraith believes the group is "too expensive" after its rally this fall. "I was a tech bull for eight weeks and it felt great," he says. "Earnings are going to surprise people on the upside, but valuations already reflect that."

Still, an element of sanity has returned to technology investing after the go-go years. One bullish sign: Goldman's Cohen will start forecasting Nasdaq levels again. She stopped doing so in early 1999 because the companies in the index had little in the way of earnings or cash flow. Cohen currently recommends a slightly overweight position in tech shares, but remains underweight in telecommunications.

The year now drawing to its inevitable close saw unusual turnover in the normally staid world of investment strategy. Elizabeth MacKay, Bear Stearns' former strategist, left Wall Street to attend Columbia Law School. Christine Callies left Merrill Lynch, and Greg Smith resigned from Prudential Securities. Marshall Acuff, a Salmon Smith Barney veteran, retired, and Byron Wien has stepped into the new position of senior U.S. investment strategist at Morgan Stanley, where he will continue to spout his own much-admired brand of wisdom. He's still skeptical about investor complacency, however. "The market is like my Aunt Rose," says Wien. "She didn't like to worry about anything," which of course concerns him.

Stock-market analysts like to study historical trends for their supposed predictive powers. And Wall Street's reigning seers repeatedly note that the market almost never falls three years in a row. Then again, before the 1990s, the U.S. stock market never produced double-digit returns for five years in a row. Which only proves that every rule has an exception, and that 2002 will be no cinch for investors. Nonetheless, happy new year.

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